GOVERNMENT SECURITIES

A Government security is a tradable instrument issued by the Central Government or the State
Governments. It acknowledges the Government’s debt obligation. Such securities are short term
(usually called treasury bills, with original maturities of less than one year) or long term (usually called
Government bonds or dated securities with original maturity of one year or more). In India, the Central
Government issues both, treasury bills and bonds or dated securities while the State Governments issue
only bonds or dated securities, which are called the State Development Loans (SDLs). Government
securities carry practically no risk of default and, hence, are called risk-free gilt-edged instruments.
Government of India also issues savings instruments (Savings Bonds, National Saving Certificates
(NSCs), etc.) or special securities (oil bonds, Food Corporation of India bonds, fertiliser bonds, power
bonds, etc.). They are, usually not fully tradable and are, therefore, not eligible to be SLR securities.

a. Treasury Bills (T-bills)

Treasury bills or T-bills, which are money market instruments, are short term debt instruments issued
by the Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364
day. Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and
redeemed at the face value at maturity. For example, a 91 day Treasury bill of Rs.100/- (face value) may
be issued at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value
of Rs.100/-. The return to the investors is the difference between the maturity value or the face value
(that is Rs.100) and the issue price (for calculation of yield on Treasury Bills please see answer to
question no. 26). The Reserve Bank of India conducts auctions usually every Wednesday to issue T-
bills. Payments for the T-bills purchased are made on the following Friday. The 91 day T-bills are
auctioned on every Wednesday. The Treasury bills of 182 days and 364 days tenure are auctioned on
alternate Wednesdays. T-bills of of 364 days tenure are auctioned on the Wednesday preceding the
reporting Friday while 182 T-bills are auctioned on the Wednesday prior to a non-reporting Fridays. The
Reserve Bank releases an annual calendar of T-bill issuances for a financial year in the last week of
March of the previous financial year. The Reserve Bank of India announces the issue details of T-bills
through a press release every week.

b. Cash Management Bills (CMBs)

1.3 Government of India, in consultation with the Reserve Bank of India, has decided to issue a new
short-term instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatches in
the cash flow of the Government. The CMBs have the generic character of T-bills but are issued for
maturities less than 91 days. Like T-bills, they are also issued at a discount and redeemed at face value
at maturity. The tenure, notified amount and date of issue of the CMBs depends upon the temporary
cash requirement of the Government. The announcement of their auction is made by Reserve Bank of
India through a Press Release which will be issued one day prior to the date of auction. The settlement
of the auction is on T+1 basis. The non-competitive bidding scheme (referred to in paragraph number
4.3 and 4.4 under question No. 4) has not been extended to the CMBs. However, these instruments are
tradable and qualify for ready forward facility. Investment in CMBs is also reckoned as an eligible
investment in Government securities by banks for SLR purpose under Section 24 of the Banking
Regulation Act, 1949. First set of CMBs were issued on May 12, 2010.
c. Dated Government Securities

Dated Government securities are long term securities and carry a fixed or floating coupon (interest rate)
which is paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated
securities can be up to 30 years.

The Public Debt Office (PDO) of the Reserve Bank of India acts as the
registry / depository of Government securities and deals with the issue,
interest payment and repayment of principal at maturity. Most of the dated
securities are fixed coupon securities.

The nomenclature of a typical dated fixed coupon Government security contains the following features -
coupon, name of the issuer, maturity and face value. For example, 7.49% GS 2017 would mean:

Coupon : 7.49% paid on face value

Name of Issuer : Government of India
Date of Issue : April 16, 2007
Maturity : April 16, 2017
Coupon Payment Dates : Half-yearly (October 16 and April 16) every year
Minimum Amount of issue/ sale : Rs.10,000

In case there are two securities with the same coupon and are maturing in the same year, then one of the
securities will have the month attached as suffix in the nomenclature. For example, 6.05% GS 2019
FEB, would mean that Government security having coupon 6.05 % that mature in February 2019 along
with the other security with the same coupon, namely,, 6.05% 2019 which is maturing in June 2019.

If the coupon payment date falls on a Sunday or a holiday, the coupon payment is made on the next
working day. However, if the maturity date falls on a Sunday or a holiday, the redemption proceeds are
paid on the previous working day itself.

Just as in the case of Treasury Bills, dated securities of both, Government of India and State
Governments, are issued by Reserve Bank through auctions. The Reserve Bank announces the auctions a
week in advance through press releases. Government Security auctions are also announced through
advertisements in major dailies. The investors, are thus, given adequate time to plan for the purchase of
government securities through such auctions.

Instruments:

i. Fixed Rate Bonds – These are bonds on which the coupon rate is fixed for the entire life of the
bond. Most Government bonds are issued as fixed rate bonds.

For example – 8.24%GS2018 was issued on April 22, 2008 for a tenor of 10 years maturing on
April 22, 2018. Coupon on this security will be paid half-yearly at 4.12% (half yearly payment
being the half of the annual coupon of 8.24%) of the face value on October 22 and April 22 of
each year.
 ii. Floating Rate Bonds – Floating Rate Bonds are securities which do not have a fixed coupon rate.
The coupon is re-set at pre-announced intervals (say, every six months or one year) by adding a
spread over a base rate. In the case of most floating rate bonds issued by the Government of
India so far,the base rate is the weighted average cut-off yield of the last three 364- day Treasury
Bill auctions preceding the coupon re-set date and the spread is decided through the auction.
Floating Rate Bonds were first issued in September 1995 in India.

For example, a Floating Rate Bond was issued on July 2, 2002 for a tenor of 15 years, thus
maturing on July 2, 2017. The base rate on the bond for the coupon payments was fixed at 6.50%
being the weighted average rate of implicit yield on 364-day Treasury Bills during the preceding
six auctions. In the bond auction, a cut-off spread (markup over the benchmark rate) of 34 basis
points (0.34%) was decided. Hence the coupon for the first six months was fixed at 6.84%.
iii. Zero Coupon Bonds – Zero coupon bonds are bonds with no coupon payments. Like Treasury
Bills, they are issued at a discount to the face value. The Government of India issued such
securities in the nineties, It has not issued zero coupon bond after that.
iv. Capital Indexed Bonds – These are bonds, the principal of which is linked to an accepted index
of inflation with a view to protecting the holder from inflation. A capital indexed bond, with the
principal hedged against inflation, was issued in December 1997. These bonds matured in 2002.
The government is currently working on a fresh issuance of Inflation Indexed Bonds wherein
payment of both, the coupon and the principal on the bonds, will be linked to an Inflation Index
(Wholesale Price Index). In the proposed structure, the principal will be indexed and the coupon
will be calculated on the indexed principal. In order to provide the holders protection against
actual inflation, the final WPI will be used for indexation.
v. Bonds with Call/ Put Options – Bonds can also be issued with features of optionality wherein the
issuer can have the option to buy-back (call option) or the investor can have the option to sell the
bond (put option) to the issuer during the currency of the bond. 6.72%GS2012 was issued on
July 18, 2002 for a maturity of 10 years maturing on July 18, 2012. The optionality on the bond
could be exercised after completion of five years tenure from the date of issuance on any coupon
date falling thereafter. The Government has the right to buyback the bond (call option) at par
value (equal to the face value) while the investor has the right to sell the bond (put option) to the
Government at par value at the time of any of the half-yearly coupon dates starting from July 18,
2007.
vi. Special Securities - In addition to Treasury Bills and dated securities issued by the Government
of India under the market borrowing programme, the Government of India also issues, from time
to time, special securities to entities like Oil Marketing Companies, Fertilizer Companies, the
Food Corporation of India, etc. as compensation to these companies in lieu of cash subsidies.
These securities are usually long dated securities carrying coupon with a spread of about 20-25
basis points over the yield of the dated securities of comparable maturity. These securities are,
however, not eligible SLR securities but are eligible as collateral for market repo transactions.
The beneficiary oil marketing companies may divest these securities in the secondary market to
banks, insurance companies / Primary Dealers, etc., for raising cash.
vii. Steps are being taken to introduce new types of instruments like STRIPS (Separate Trading of
Registered Interest and Principal of Securities). Accordingly, guidelines for stripping and
reconstitution of Government securities have been issued. STRIPS are instruments wherein each
cash flow of the fixed coupon security is converted into a separate tradable Zero Coupon Bond
and traded. For example, when Rs.100 of the 8.24%GS2018 is stripped, each cash flow of
 coupon (Rs.4.12 each half year) will become coupon STRIP and the principal payment (Rs.100
at maturity) will become a principal STRIP. These cash flows are traded separately as
independent securities in the secondary market. STRIPS in Government securities will ensure
availability of sovereign zero coupon bonds, which will facilitate the development of a market
determined zero coupon yield curve (ZCYC). STRIPS will also provide institutional investors
with an additional instrument for their asset- liability management. Further, as STRIPS have zero
reinvestment risk, being zero coupon bonds, they can be attractive to retail/non-institutional
investors. The process of stripping/reconstitution of Government securities is carried out at RBI,
Public Debt Office (PDO) in the PDO-NDS (Negotiated Dealing System) at the option of the
holder at any time from the date of issuance of a Government security till its maturity. All dated
Government securities, other than floating rate bonds, having coupon payment dates on 2nd
January and 2nd July, irrespective of the year of maturity are eligible for
Stripping/Reconstitution. Eligible Government securities held in the Subsidiary General Leger
(SGL)/Constituent Subsidiary General Ledger (CSGL) accounts maintained at the PDO, RBI,
Mumbai. Physical securities shall not be eligible for stripping/reconstitution. Minimum amount
of securities that needs to be submitted for stripping/reconstitution will be Rs. 1 crore (Face
Value) and multiples thereof.

d. State Development Loans (SDLs)

State Governments also raise loans from the market. SDLs are dated securities issued through an auction
similar to the auctions conducted for dated securities issued by the Central Government (see question 3
below). Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like
dated securities issued by the Central Government, SDLs issued by the State Governments qualify for
SLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing by
eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).

Primary (Urban) Co-operative Banks

Section 24 of the Banking Regulation Act 1949, (as applicable to co-operative societies) provides that
every primary (urban) cooperative bank shall maintain liquid assets, which at the close of business on
any day, should not be less than 25 percent of its demand and time liabilities in India (in addition to the
minimum cash reserve requirement). Such liquid assets shall be in the form of cash, gold or
unencumbered Government and other approved securities. This is commonly referred to as the Statutory
Liquidity Ratio (SLR) requirement.

All primary (urban) co-operative banks (UCBs) are presently required to invest a certain minimum level
of their SLR holdings in the form of Government and other approved securities as indicated below:

a. Scheduled UCBs have to hold 25 per cent of their SLR requirement in Government and other
approved securities.
b. Non-scheduled UCBs with Demand and Time Liabilities (DTL) more than Rs. 25 crore have to
hold 15 per cent of their SLR requirement in Government and other approved securities.
c. Non-scheduled UCBs with DTL less than Rs. 25 crore have to hold 10 per cent of their SLR
requirements in Government and other approved securities.
B. Rural Co-operative Banks

As per Section 24 of the Banking Regulation Act 1949, the State Co-operative Banks (SCBs) and the
District Central Co-operative Banks (DCCBs) are required to maintain in cash, gold or unencumbered
approved securities, valued at a price not exceeding the current market price, an amount which shall not,
at the close of business on any day, be less than 25 per cent of its demand and time liabilities as part of
the SLR requirement. DCCBs are allowed to meet their SLR requirement by maintaining cash balances
with their respective State Co-operative Bank.

C. Regional Rural Banks (RRBs)

Since April 2002, all the RRBs are required to maintain their entire Statutory Liquidity Ratio (SLR)
holdings in Government and other approved securities. The current SLR requirement for the RRBs is 24
percent of their Demand and Time Liabilities (DTL).

Presently, RRBs have been exempted from the 'mark to market' norms in respect of their SLR-securities.
Accordingly, RRBs have been given freedom to classify their entire investment portfolio of SLR-
securities under 'Held to Maturity' and value them at book value.

D. Provident funds and other entities

The non-Government provident funds, superannuation funds and gratuity funds are required by the
Central Government, effective from January 24, 2005, to invest 40 per cent of their incremental
accretions in Central and State Government securities, and/or units of gilt funds regulated by the
Securities and Exchange Board of India (SEBI) and any other negotiable security fully and
unconditionally guaranteed by the Central/State Governments. The exposure of a trust to any individual
gilt fund, however, should not exceed five per cent of its total portfolio at any point of time. The
investment guidelines for non-government PFs have been recently revised in terms of which investments
up to 55% of the investible funds are permitted in a basket of instruments consisting of Central
Government securities, State Government securities and units of gilt funds, effective from April 2009.

Issue of the Government Securities

Government securities are issued through auctions conducted by the RBI. Auctions are conducted on
the electronic platform called the NDS – Auction platform. Commercial banks, scheduled urban co-
operative banks, Primary Dealers, insurance companies and provident funds, who maintain funds
account (current account) and securities accounts (SGL account) with RBI, are members of this
electronic platform. All members of PDO-NDS can place their bids in the auction through this electronic
platform. All non-NDS members including non-scheduled urban co-operative banks can participate in
the primary auction through scheduled commercial banks or Primary Dealers. For this purpose, the
urban co-operative banks need to open a securities account with a bank / Primary Dealer – such an
account is called a Gilt Account. A Gilt Account is a dematerialized account maintained by a scheduled
commercial bank or Primary Dealer for its constituent (e.g., a non-scheduled urban co-operative bank).

The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar
which contains information about the amount of borrowing, the tenor of security and the likely period
during which auctions will be held. A Notification and a Press Communique giving exact particulars of
the securities, viz., name, amount, type of issue and procedure of auction are issued by the Government
of India about a week prior to the actual date of auction. RBI places the notification and a Press Release
on its website (www.rbi.org.in) and also issues an advertisement in leading English and Hindi
newspapers. Information about auctions is also available with the select branches of public and private
sector banks and the Primary Dealers.

Types of auctions

Prior to introduction of auctions as the method of issuance, the interest rates were administratively fixed
by the Government. With the introduction of auctions, the rate of interest (coupon rate) gets fixed
through a market based price discovery process.

An auction may either be yield based or price based.

i. Yield Based Auction: A yield based auction is generally conducted when a new Government
security is issued. Investors bid in yield terms up to two decimal places (for example, 8.19 per
cent, 8.20 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at
the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the
coupon rate for the security. Successful bidders are those who have bid at or below the cut-off
yield. Bids which are higher than the cut-off yield are rejected. An illustrative example of the
yield based auction is given below:

Yield based auction of a new security

 Maturity Date: September 8, 2018

 Coupon: It is determined in the auction (8.22% as shown in the
illustration below)
 Auction date: September 5, 2008
 Auction settlement date: September 8, 2008*
 Notified Amount: Rs.1000 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008

under T+1 cycle.

Details of bids received in the increasing order of bid yields

Price* with
Amount of bid Cummulative
Bid No. Bid Yield coupon as
(Rs. crore) amount (Rs.Cr)
8.22%
1 8.19% 300 300 100.19
2 8.20% 200 500 100.14
3 8.20% 250 750 100.13
4 8.21% 150 900 100.09
5 8.22% 100 1000 100
6 8.22% 100 1100 100
7 8.23% 150 1250 99.93
 8 8.24% 100 1350 99.87
The issuer would get the notified amount by accepting bids up to 5. Since
the bid number 6 also is at the same yield, bid numbers 5 and 6 would get
allotment pro-rata so that the notified amount is not exceeded. In the
above case each would get Rs. 50 crore. Bid numbers 7 and 8 are rejected
as the yields are higher than the cut-off yield.
*Price corresponding to the yield is determined as per the relationship
given under YTM calculation in question 24.

ii. Price Based Auction: A price based auction is conducted when Government of India re-issues
securities issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security
(e.g., Rs.102.00, Rs.101.00, Rs.100.00, Rs.99.00, etc., per Rs.100/-). Bids are arranged in
descending order and the successful bidders are those who have bid at or above the cut-off price.
Bids which are below the cut-off price are rejected. An illustrative example of price based
auction is given below:

Price based auction of an existing security 8.24% GS 2018

 Maturity Date: April 22, 2018

 Coupon: 8.24%
 Auction date: September 5, 2008
 Auction settlement date: September 8, 2008*
 Notified Amount: Rs.1000 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008 under T+1 cycle.

Details of bids received in the decreasing order of bid price

Amount of bid Implicit Cumulative
Bid no. Price of bid
(Rs. Cr) yield amount
1 100.31 300 8.1912% 300
2 100.26 200 8.1987% 500
3 100.25 250 8.2002% 750
4 100.21 150 8.2062% 900
5 100.20 100 8.2077% 1000
6 100.20 100 8.2077% 1100
7 100.16 150 8.2136% 1250
8 100.15 100 8.2151% 1350
The issuer would get the notified amount by accepting bids up to 5. Since
the bid number 6 also is at the same price, bid numbers 5 and 6 would get
allotment in proportion so that the notified amount is not exceeded. In the
above case each would get Rs. 50 crore. Bid numbers 7 and 8 are rejected
as the price quoted is less than the cut-off price.

Depending upon the method of allocation to successful bidders, auction could be classified as Uniform
Price based and Multiple Price based. In a Uniform Price auction, all the successful bidders are
required to pay for the allotted quantity of securities at the same rate, i.e., at the auction cut-off rate,
irrespective of the rate quoted by them. On the other hand, in a Multiple Price auction, the successful
bidders are required to pay for the allotted quantity of securities at the respective price / yield at which
they have bid. In the example under (ii) above, if the auction was Uniform Price based, all bidders
would get allotment at the cut-off price, i.e., Rs.100.20. On the other hand, if the auction was Multiple
Price based, each bidder would get the allotment at the price he/ she has bid, i.e., bidder 1 at Rs.100.31,
bidder 2 at Rs.100.26 and so on.

An investor may bid in an auction under either of the following categories:

i. Competitive Bidding : In a competitive bidding, an investor bids at a specific price / yield and is
allotted securities if the price / yield quoted is within the cut-off price / yield. Competitive bids are made
by well informed investors such as banks, financial institutions, primary dealers, mutual funds, and
insurance companies. The minimum bid amount is Rs.10,000 and in multiples of Rs.10,000 thereafter.
Multiple bidding is also allowed, i.e., an investor may put in several bids at various price/ yield levels.

ii. Non-Competitive Bidding : With a view to providing retail investors, who may lack skill and
knowledge to participate in the auction directly, an opportunity to participate in the auction process, the
scheme of non-competitive bidding in dated securities was introduced in January 2002. Non-competitive
bidding is open to individuals, HUFs, RRBs, co-operative banks, firms, companies, corporate bodies,
institutions, provident funds, and trusts. Under the scheme, eligible investors apply for a certain amount
of securities in an auction without mentioning a specific price / yield. Such bidders are allotted securities
at the weighted average price / yield of the auction. In the illustration given under 4.1 (ii) above, the
notified amount being Rs.1000 crore, the amount reserved for non-competitive bidding will be Rs.50
crore (5 per cent of the notified amount as indicated below). Non-competitive bidders will be allotted at
the weighted average price which is Rs.100.26 in the given illustration. The participants in non-
competitive bidding are, however, required to hold a gilt account with a bank or PD. Regional Rural
Banks and co-operative banks which hold SGL and Current Account with the RBI can also participate
under the scheme of non-competitive bidding without holding a gilt account.

In every auction of dated securities, a maximum of 5 per cent of the notified amount is reserved for such
non-competitive bids. In the case of auction for Treasury Bills, the amount accepted for non-competitive
bids is over and above the notified amount and there is no limit placed. However, non-competitive
bidding in Treasury Bills is available only to State Governments and other select entities and is not
available to the co-operative banks. Only one bid is allowed to be submitted by an investor either
through a bank or Primary Dealer. For bidding under the scheme, an investor has to fill in an
undertaking and send it along with the application for allotment of securities through a bank or a
Primary Dealer. The minimum amount and the maximum amount for a single bid is Rs.10,000 and Rs.2
crore respectively in the case of an auction of dated securities. A bank or a Primary Dealer can charge an
investor up to maximum of 6 paise per Rs.100 of application money as commission for rendering their
services. In case the total applications received for non-competitive bids exceed the ceiling of 5 per cent
of the notified amount of the auction for dated securities, the bidders are allotted securities on a pro-rata
basis.

Non-competitive bidding scheme has been introduced in the State Government securities (SDLs) from
August 2009. The aggregate amount reserved for the purpose in the case of SDLs is 10% of the notified
amount (Rs.100 Crore for a notified amount of Rs.1000 Crore) and the maximum amount an investor
can bid per auction is capped at 1% of the notified amount (as against Rs.2 Crore in Central Government
securities). The bidding and allotment procedure is similar to that of Central Government securities.

Open Market Operations (OMOs)

OMOs are the market operations conducted by the Reserve Bank of India by way of sale/ purchase of
Government securities to/ from the market with an objective to adjust the rupee liquidity conditions in
the market on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts to
sale of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are
tight, the RBI will buy securities from the market, thereby releasing liquidity into the market.

buyback of Government securities

Buyback of Government securities is a process whereby the Government of India and State
Governments buy back their existing securities from the holders. The objectives of buyback can be
reduction of cost (by buying back high coupon securities), reduction in the number of outstanding
securities and improving liquidity in the Government securities market (by buying back illiquid
securities) and infusion of liquidity in the system. Governments make provisions in their budget for
buying back of existing securities. Buyback can be done through an auction process or through the
secondary market route, i.e., NDS/NDS-OM.

Liquidity Adjustment Facility (LAF)

LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding
RRBs) and primary dealers to avail of liquidity in case of requirement or park excess funds with the RBI
in case of excess liquidity on an overnight basis against the collateral of Government securities
including State Government securities. Basically LAF enables liquidity management on a day to day
basis. The operations of LAF are conducted by way of repurchase with RBI being the counter-party to
all the transactions. The interest rate in LAF is fixed by the RBI from time to time. Currently the rate of
interest on repo under LAF (borrowing by the participants) is 6.25% and that of reverse repo (placing
funds with RBI) is 5.25%. LAF is an important tool of monetary policy and enables RBI to transmit
interest rate signals to the market.

Trading in Government securities

There is an active secondary market in Government securities. The securities can be bought / sold in the
secondary market either (i) Over the Counter (OTC) or (ii) through the Negotiated Dealing System
(NDS) or (iii) the Negotiated Dealing System-Order Matching (NDS-OM).

i. Over the Counter (OTC)/ Telephone Market

In this market, a participant, who wants to buy or sell a government security, may contact a bank /
Primary Dealer / financial institution either directly or through a broker registered with SEBI and
negotiate for a certain amount of a particular security at a certain price. Such negotiations are usually
done on telephone and a deal may be struck if both counterparties agree on the amount and rate. In the
case of a buyer, like an urban co-operative bank wishing to buy a security, the bank's dealer (who is
authorized by the bank to undertake transactions in Government Securities) may get in touch with other
market participants over telephone and obtain quotes. Should a deal be struck, the bank should record
the details of the trade in a deal slip and send a trade confirmation to the counterparty. The dealer must
exercise due diligence with regard to the price quoted by verifying with available sources. All trades
undertaken in OTC market are reported on the secondary market module of the NDS.

ii. Negotiated Dealing System

The Negotiated Dealing System (NDS) for electronic dealing and reporting of transactions in
government securities was introduced in February 2002. It facilitates the members to submit
electronically, bids or applications for primary issuance of Government Securities when auctions are
conducted. NDS also provides an interface to the Securities Settlement System (SSS) of the Public Debt
Office, RBI, Mumbai thereby facilitating settlement of transactions in Government Securities (both
outright and repos) conducted in the secondary market. Membership to the NDS is restricted to members
holding SGL and/or Current Account with the RBI, Mumbai.

In August, 2005, RBI introduced an anonymous screen based order matching module on NDS, called
NDS-OM. This is an order driven electronic system, where the participants can trade anonymously by
placing their orders on the system or accepting the orders already placed by other participants. NDS-OM
is operated by the Clearing Corporation of India Ltd. (CCIL) on behalf of the RBI (Please see answer to
the question no.19 about CCIL). Direct access to the NDS-OM system is currently available only to
select financial institutions like Commercial Banks, Primary Dealers, Insurance Companies, Mutual
Funds, etc. Other participants can access this system through their custodians, i.e., with whom they
maintain Gilt Accounts. The custodians place the orders on behalf of their customers like the urban co-
operative banks. The advantages of NDS-OM are price transparency and better price discovery.

Gilt Account holders have been given indirect access to NDS through custodian institutions. A member
(who has the direct access) can report on the NDS the transaction of a Gilt Account holder in
government securities. Similarly, Gilt Account holders have also been given indirect access to NDS-OM
through the custodians. However, currently two gilt account holders of the same custodian are not
permitted to undertake repo transactions between themselves.

iii. Stock Exchanges

Facilities are also available for trading in Government securities on stock exchanges (NSE, BSE) which
cater to the needs of retail investors.

Major players in the Government Securities market

Major players in the Government securities market include commercial banks and primary dealers
besides institutional investors like insurance companies. Primary Dealers play an important role as
market makers in Government securities market . Other participants include co-operative banks,
regional rural banks, mutual funds, provident and pension funds. Foreign Institutional Investors (FIIs)
are allowed to participate in the Government securities market within the quantitative limits prescribed
from time to time. Corporates also buy/ sell the government securities to manage their overall portfolio
risk.

Dealing transactions

For every transaction entered into by the trading desk, a deal slip should be generated which should
contain data relating to nature of the deal, name of the counter-party, whether it is a direct deal or
through a broker (if it is through a broker, name of the broker), details of security, amount, price,
contract date and time and settlement date. The deal slips should be serially numbered and verified
separately to ensure that each deal slip has been properly accounted for. Once the deal is concluded, the
deal slip should be immediately passed on to the back office (it should be separate and distinct from the
front office) for recording and processing. For each deal, there must be a system of issue of
confirmation to the counter-party. The timely receipt of requisite written confirmation from the counter-
party, which must include all essential details of the contract, should be monitored by the back office.
With The need for counterparty confirmation of deals matched on NDS-OM will not arise, as NDS-OM
is an anonymous automated order matching system. However, in case of trades finalized in the OTC
market and reported on NDS, confirmations have to be submitted by the counterparties in the system
i.e., NDS.

Once a deal has been concluded through a broker, there should not be any substitution of the counter-
party by the broker. Similarly, the security sold / purchased in a deal should not be substituted by
another security under any circumstances. A maker-checker framework should be implemented to
prevent any individual misdemeanor. It should be ensured that the same person is not carrying out the
functions of maker (one who inputs the data) and checker (one who verifies and authorizes the data) on
the system.

On the basis of vouchers passed by the back office (which should be done after verification of actual
contract notes received from the broker / counter party and confirmation of the deal by the counter
party), the books of account should be independently prepared.

Why does the price of Government security change?

The price of a Government security, like other financial instruments, keeps fluctuating in the secondary
market. The price is determined by demand and supply of the securities. Specifically, the prices of
Government securities are influenced by the level and changes in interest rates in the economy and other
macro-economic factors, such as, expected rate of inflation, liquidity in the market, etc. Developments
in other markets like money, foreign exchange, credit and capital markets also affect the price of the
Government securities. Further, developments in international bond markets, specifically the US
Treasuries affect prices of Government securities in India. Policy actions by RBI (e.g., announcements
regarding changes in policy interest rates like Repo Rate, Cash Reserve Ratio, Open Market Operations,
etc.) can also affect the prices of Government securities.

Reporting Government securities transactions

Transactions undertaken between market participants in the OTC/telephone market are expected to be
reported on the NDS platform within 15 minutes after the deal is put through over telephone. All OTC
trades are required to be mandatorily reported on the secondary market module of the NDS for
settlement. Reporting on NDS is a four stage process wherein the seller of the security has to initiate the
reporting followed by confirmation by the buyer. This is further followed by issue of confirmation by
the seller’s back office on the system and reporting is complete with the last stage wherein the buyer’s
back office confirms the deal. The system architecture incorporates maker-checker model to preempt
individual mistakes as well as misdemeanor.

Reporting on behalf of entities maintaining gilt accounts with the custodians is done by the respective
custodians in the same manner as they do in case of their own trades i.e., proprietary trades. The
securities leg of these trades settle in the CSGL account of the custodian. Once the reporting is
complete, the NDS system accepts the trade. Information on all such successfully reported trades flow to
the clearing house i.e., the CCIL.

In the case of NDS-OM, participants place orders (price and quantity) on the system. Participants can
modify / cancel their orders. Order could be a bid for purchase or offer for sale of securities. The system,
in turn will match the orders based on price and time priority. That is, it matches bids and offers of the
same prices with time priority. The NDS-OM system has separate screen for the Central Government,
State Government and Treasury bill trading. In addition, there is a screen for odd lot trading for
facilitating trading by small participants in smaller lots of less than Rs. 5 crore (i.e., the standard market
lot). The NDS-OM platform is an anonymous platform wherein the participants will not know the
counterparty to the trade. Once an order is matched, the deal ticket gets generated automatically and the
trade details flow to the CCIL. Due to anonymity offered by the system, the pricing is not influenced by
the participants’ size and standing.

Settlement in Government securitie

Primary Market

Once the allotment process in the primary auction is finalized, the successful participants are advised of
the consideration amounts that they need to pay to the Government on settlement day. The settlement
cycle for dated security auction is T+1, whereas for that of Treasury bill auction is T+2. On the
settlement date, the fund accounts of the participants are debited by their respective consideration
amounts and their securities accounts (SGL accounts) are credited with the amount of securities that
they were allotted.

Secondary Market

The transactions relating to Government securities are settled through the member’s securities / current
accounts maintained with the RBI, with delivery of securities and payment of funds being done on a net
basis. The Clearing Corporation of India Limited (CCIL) guarantees settlement of trades on the
settlement date by becoming a central counter-party to every trade through the process of novation, i.e.,
it becomes seller to the buyer and buyer to the seller.

All outright secondary market transactions in Government Securities are settled on T+1 basis. However,
in case of repo transactions in Government securities, the market participants will have the choice of
settling the first leg on either T+0 basis or T+1 basis as per their requirement.
Shut period?

‘Shut period’ means the period for which the securities can not be delivered. During the period under
shut, no settlements/ delivery of the security which is under shut will be allowed. The main purpose of
having a shut period is to facilitate servicing of the securities viz., finalizing the payment of coupon and
redemption proceeds and to avoid any change in ownership of securities during this process. Currently
the shut period for the securities held in SGL accounts is one day. For example, the coupon payment
dates for the security 6.49% CG 2015 are June 8 and December 8 of every year. The shut period will fall
on June 7 and December 7 for this security and trading in this security for settlement on these two dates
is not allowed.

Delivery versus Payment (DvP)

Delivery versus Payment (DvP) is the mode of settlement of securities wherein the transfer of securities
and funds happen simultaneously. This ensures that unless the funds are paid, the securities are not
delivered and vice versa. DvP settlement eliminates the settlement risk in transactions. There are three
types of DvP settlements, viz., DvP I, II and III which are explained below;

i. DvP I – The securities and funds legs of the transactions are settled on a gross basis, that is, the
settlements occur transaction by transaction without netting the payables and receivables of the
participant.

ii. DvP II – In this method, the securities are settled on gross basis whereas the funds are settled on a net
basis, that is, the funds payable and receivable of all transactions of a party are netted to arrive at the
final payable or receivable position which is settled.

iii. DvP III – In this method, both the securities and the funds legs are settled on a net basis and only the
final net position of all transactions undertaken by a participant is settled.

Liquidity requirement in a gross mode is higher than that of a net mode since the payables and
receivables are set off against each other in the net mode.

Clearing Corporation of India Limited (CCIL)

The CCIL is the clearing agency for Government securities. It acts as a Central Counter Party (CCP) for
all transactions in Government securities by interposing itself between two counterparties. In effect,
during settlement, the CCP becomes the seller to the buyer and buyer to the seller of the actual
transaction. All outright trades undertaken in the OTC market and on the NDS-OM platform are cleared
through the CCIL. Once CCIL receives the trade information, it works out participant-wise net
obligations on both the securities and the funds leg. The payable / receivable position of the constituents
(gilt account holders) is reflected against their respective custodians. CCIL forwards the settlement file
containing net position of participants to the RBI where settlement takes place by simultaneous transfer
of funds and securities under the ‘Delivery versus Payment’ system. CCIL also guarantees settlement of
all trades in Government securities. That means, during the settlement process, if any participant fails to
provide funds/ securities, CCIL will make the same available from its own means. For this purpose,
CCIL collects margins from all participants and maintains ‘Settlement Guarantee Fund’.
‘When Issued’ market

'When Issued', a short term of "when, as and if issued", indicates a conditional transaction in a security
notified for issuance but not yet actually issued. All "When Issued" transactions are on an "if" basis, to
be settled if and when the security is actually issued. 'When Issued' transactions in the Central
Government securities have been permitted to all NDS-OM members and have to be undertaken only on
the NDS-OM platform. ‘When Issued’ market helps in price discovery of the securities being auctioned
as well as better distribution of the auction stock.

What are the basic mathematical concepts one should know for calculations involved in bond
prices and yields?

The time value of money functions related to calculation of Present Value (PV), Future Value (FV), etc.
are important mathematical concepts related to bond market.

Time Value of Money

Money has time value as a Rupee today is more valuable and useful than a Rupee a year later.

The concept of time value of money is based on the premise that an investor prefers to receive a
payment of a fixed amount of money today, rather than an equal amount in the future, all else being
equal. In particular, if one receives the payment today, one can then earn interest on the money until that
specified future date. Further, in an inflationary environment, a Rupee today will have greater
purchasing power than after a year.

Present value of a future sum

The present value formula is the core formula for the time value of money.
The present value (PV) formula has four variables, each of which can be solved for:
Present Value (PV) is the value at time=0
Future Value (FV) is the value at time=n
i is the rate at which the amount will be compounded each period
n is the number of periods

An illustration

Taking the cash flows as;

 Period (in Yrs) 1 2 3
Amount 100 100 100

Assuming that the interest rate is at 10% per annum;

The discount factor for each year can be calculated as 1/(1+interest rate)^no. of years

The present value can then be worked out as Amount x discount factor

The PV of Rs.100 accruing after;

Year Amount discount factor P.V.

1 100 0.9091 90.91
2 100 0.8264 82.64
3 100 0.7513 75.13

The cumulative present value = 90.91+82.64+75.13 = Rs.248.69

Net Present Value (NPV)

Net present value (NPV) or net present worth (NPW) is defined as the present value of net cash
flows. It is a standard method for using the time value of money to appraise long-term projects. Used for
capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in
present value (PV) terms, once financing charges are met. Use Advanced Financial Calculators.

Formula

Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore

In the illustration given above under the Present value, if the three cash flows accrues on a deposit of Rs.
240, the NPV of the investment is equal to 248.69-240 = Rs.8.69

How is the Price of a bond calculated? What is the total consideration amount of a trade and what
is accrued interest?
The price of a bond is nothing but the sum of present value all future cash flows of the bond. The
interest rate used for discounting the cash flows is the Yield to Maturity (YTM) of the bond. Price can
be calculated using the excel function ‘Price’

Accrued interest is the interest calculated for the broken period from the last coupon day till a day prior
to the settlement date of the trade. Since the seller of the security is holding the security for the period
up to the day prior to the settlement date of the trade, he is entitled to receive the coupon for the period
held. During settlement of the trade, the buyer of security will pay the accrued interest in addition to the
agreed price and pays the ‘consideration amount’.

An illustration is given below;

For a trade of Rs.5 crore (face value) of security 6.49%2015 for settlement date August 26, 2009 at a
price of Rs.96.95, the consideration amount payable to the seller of the security is worked out below;

Here the price quoted is called ‘clean price’ as the ‘accrued interest’ component is not added to it.

Accrued interest:

The last coupon date being June 8, 2009, the number of days in broken period till August 25, 2009 (one
day prior to settlement date) are 78.

The accrued interest on Rs.100 face value for 78 days = 6.49x(78/360)

= Rs.1.4062

When we add the accrued interest component to the ‘clean price’, the resultant price is called the ‘dirty
price’. In the instant case, it is 96.95+1.4062 = Rs.98.3562

The total consideration amount = Face value of trade x dirty price

= 5,00,00,000 x (98.3562/100)
= Rs.4,91,78,083.33

The relationship between yield and price of a bond

If interest rates or market yields rise, the price of a bond falls. Conversely, if interest rates or market
yields decline, the price of the bond rises. In other words, the yield of a bond is inversely related to its
price. The relationship between yield to maturity and coupon rate of bond may be stated as follows:

 When the market price of the bond is less than the face value, i.e., the bond sells at a discount,
YTM > current yield > coupon yield.
 When the market price of the bond is more than its face value, i.e., the bond sells at a premium,
coupon yield > current yield > YTM.
 When the market price of the bond is equal to its face value, i.e., the bond sells at par, YTM =
current yield = coupon yield.

How is the yield of a bond calculated?

An investor who purchases a bond can expect to receive a return from one or more of the following
sources:

 The coupon interest payments made by the issuer;

 Any capital gain (or capital loss) when the bond is sold; and
 Income from reinvestment of the interest payments that is interest-on-interest.

The three yield measures commonly used by investors to measure the potential return from investing in
a bond are briefly described below:

i) Coupon Yield

The coupon yield is simply the coupon payment as a percentage of the face value. Coupon yield refers to
nominal interest payable on a fixed income security like Government security. This is the fixed return
the Government (i.e., the issuer) commits to pay to the investor. Coupon yield thus does not reflect the
impact of interest rate movement and inflation on the nominal interest that the Government pays.

Coupon yield = Coupon Payment / Face Value

Illustration:
Coupon: 8.24
Face Value: Rs.100
Market Value: Rs.103.00
Coupon yield = 8.24/100 = 8.24%

ii) Current Yield

The current yield is simply the coupon payment as a percentage of the bond’s purchase price; in other
words, it is the return a holder of the bond gets against its purchase price which may be more or less than
the face value or the par value. The current yield does not take into account the reinvestment of the
interest income received periodically.

Current yield = (Annual coupon rate / Purchase price)X100

Illustration:
The current yield for a 10 year 8.24% coupon bond selling for Rs.103.00 per Rs.100 par value is
calculated below:
Annual coupon interest = 8.24% x Rs.100 = Rs.8.24
Current yield = (8.24/Rs.103)X100 = 8.00%

The current yield considers only the coupon interest and ignores other sources of return that will affect
an investor’s return.

iii) Yield to Maturity

Yield to Maturity (YTM) is the expected rate of return on a bond if it is held until its maturity. The price
of a bond is simply the sum of the present values of all its remaining cash flows. Present value is
calculated by discounting each cash flow at a rate; this rate is the YTM. Thus YTM is the discount rate
which equates the present value of the future cash flows from a bond to its current market price. In
other words, it is the internal rate of return on the bond. The calculation of YTM involves a trial-and-
error procedure. A calculator or software can be used to obtain a bond’s yield-to-maturity easily

YTM Calculation

YTM could be calculated manually as well as using functions in any standard spread sheet like MS
Excel.

Manual (Trial and Error) Method

Manual or trial and error method is complicated because Government securities have many cash flows
running into future. This is explained by taking an example below.

Take a two year security bearing a coupon of 8% and a price of say Rs. 102 per face value of Rs. 100;
the YTM could be calculated by solving for ‘r’ below. Typically it involves trial and error by taking a
value for ‘r’ and solving the equation and if the right hand side is more than 102, take a higher value of
‘r’ and solve again. Linear interpolation technique may also be used to find out exact ‘r’ once we have
two ‘r’ values so that the price value is more than 102 for one and less than 102 for the other value.

102 = 4/(1+r/2)1+ 4/(1+r/2)2 + 4/(1+r/2)3 + 104/(1+r/2)4

Spread Sheet Method using MS Excel

In the MS Excel programme, the following function could be used for calculating the yield of
periodically coupon paying securities, given the price.

YIELD (settlement,maturity,rate,price,redemption,frequency,basis)

Wherein;

Settlement is the security's settlement date. The security settlement date is the date on which the security
and funds are exchanged.Maturity is the security's maturity date. The maturity date is the date when the
security expires.

Rate is the security's annual coupon rate.

Price is the security's price per Rs.100 face value.
Redemption is the security's redemption value per Rs.100 face value.
Frequency is the number of coupon payments per year. (2 for Government bonds in India)
Basis is the type of day count basis to use. (4 for Government bonds in India which uses 30/360 basis)

Treasury Bill Yield

It is calculated as per the following formula

Wherein;

P – Purchase price
D – Days to maturity
Day Count: For Treasury Bills, D = [actual number of days to maturity/365]

Illustration
Assuming that the price of a 91 day Treasury bill at issue is Rs.98.20, the yield on the same would be

After say, 41 days, if the same Treasury bill is trading at a price of Rs. 99, the yield would then be

Note that the remaining maturity of the treasury bill is 50 days (91-41).

Risks with Government Securities

Government securities are generally referred to as risk free instrumentsas sovereigns are not expected to
default on their payments. However, as is the case with any financial instrument, there are risks
associated with holding the Government securities. Hence, it is important to identify and understand
such risks and take appropriate measures for mitigation of the same. The following are the major risks
associated with holding Government securities.

Market risk – Market risk arises out of adverse movement of prices of the securities that are held by an
investor due to changes in interest rates. This will result in booking losses on marking to market or
realizing a loss if the securities are sold at the adverse prices. Small investors, to some extent, can
mitigate market risk by holding the bonds till maturity so that they can realize the yield at which the
securities were actually bought.
Reinvestment risk – Cash flows on a Government security includes fixed coupon every half year and
repayment of principal at maturity. These cash flows need to be reinvested whenever they are paid.
Hence there is a risk that the investor may not be able to reinvest these proceeds at profitable rates due to
changes in interest rate scenario.

Liquidity risk – Liquidity risk refers to the inability of an investor to liquidate (sell) his holdings due to
non availability of buyers for the security, i.e., no trading activity in that particular security. Usually,
when a liquid bond of fixed maturity is bought, its tenor gets reduced due to time decay. For example, a
10 year security will become 8 year security after 2 years due to which it may become illiquid. Due to
illiquidity, the investor may need to sell at adverse prices in case of urgent funds requirement. However,
in such cases, eligible investors can participate in market repo and borrow the money against the
collateral of the securities.

Risk Mitigation

Holding securities till maturity could be a strategy through which one could avoid market risk.
Rebalancing the portfolio wherein the securities are sold once they become short term and new
securities of longer tenor are bought could be followed to manage the portfolio risk. However,
rebalancing involves transaction and other costs and hence needs to be used judiciously. Market risk and
reinvestment risk could also be managed through Asset Liability Management (ALM) by matching the
cash flows with liabilities. ALM could also be undertaken by matching the duration of the cash flows.

Advanced risk management techniques involve use of derivatives like Interest Rate Swaps (IRS)
through which the nature of cash flows could be altered. However, these are complex instruments
requiring advanced level of expertise for proper understanding. Adequate caution, therefore, need to be
observed for undertaking the derivatives transactions and such transactions should be undertaken only
after having complete understanding of the associated risks and complexities.

Money Market

While the Government securities market generally caters to the investors with a long term investment
horizon, the money market provides investment avenues of short term tenor. Money market transactions
are generally used for funding the transactions in other markets including Government securities market
and meeting short term liquidity mismatches. By definition, money market is for a maximum tenor of up
to one year. Within the one year, depending upon the tenors, money market is classified into:

i. Overnight market - The tenor of transactions is one working day.

ii. Notice money market – The tenor of the transactions is from 2 days to 14 days.
Iii. Term money market – The tenor of the transactions is from 15 days to one year.

Money market instruments include call money, repos, Treasury bills, Commercial Paper, Certificate of
Deposit and Collateralized Borrowing and Lending Obligations (CBLO).

Call money market

Call money market is a market for uncollateralized lending and borrowing of funds. This market is
predominantly overnight and is open for participation only to scheduled commercial banks and the
primary dealers.

Repo market

Repo or ready forward contact is an instrument for borrowing funds by selling securities with an
agreement to repurchase the said securities on a mutually agreed future date at an agreed price which
includes interest for the funds borrowed.

The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of
securities with an agreement to resell the said securities on a mutually agreed future date at an agreed
price which includes interest for the funds lent.

It can be seen from the definition above that there are two legs to the same transaction in a repo/ reverse
repo. The duration between the two legs is called the ‘repo period’. Predominantly, repos are undertaken
on overnight basis, i.e., for one day period. Settlement of repo transactions happens along with the
outright trades in government securities.

The consideration amount in the first leg of the repo transactions is the amount borrowed by the seller of
the security. On this, interest at the agreed ‘repo rate’ is calculated and paid along with the consideration
amount of the second leg of the transaction when the borrower buys back the security. The overall effect
of the repo transaction would be borrowing of funds backed by the collateral of Government securities.

The money market is regulated by the Reserve Bank of India. All the above mentioned money market
transactions should be reported on the electronic platform called the Negotiated Dealing System (NDS).

As part of the measures to develop the corporate debt market, RBI has permitted select entities
(scheduled commercial banks excluding RRBs and LABs, PDs, all-India FIs, NBFCs, mutual funds,
housing finance companies, insurance companies) to undertake repo in corporate debt securities. This is
similar to repo in Government securities except that corporate debt securities are used as collateral for
borrowing funds. Only listed corporate debt securities that are rated ‘AA’ or above by the rating
agencies are eligible to be used for repo. Commercial paper, certificate of deposit, non-convertible
debentures of original maturity less than one year are not eligible for the purpose. These transactions
take place in the OTC market and are required to be reported on FIMMDA platform within 15 minutes
of the trade for dissemination of information. They are also to be reported on the clearing house of any
of the exchanges for the purpose of clearing and settlement.

Collateralised Borrowing and Lending Obligation (CBLO)

CBLO is another money market instrument operated by the Clearing Corporation of India Ltd. (CCIL),
for the benefit of the entities who have either no access to the inter bank call money market or have
restricted access in terms of ceiling on call borrowing and lending transactions. CBLO is a discounted
instrument available in electronic book entry form for the maturity period ranging from one day to
ninety days (up to one year as per RBI guidelines). In order to enable the market participants to borrow
and lend funds, CCIL provides the Dealing System through Indian Financial Network (INFINET), a
closed user group to the Members of the Negotiated Dealing System (NDS) who maintain Current
account with RBI and through Internet for other entities who do not maintain Current account with RBI.

Membership to the CBLO segment is extended to entities who are RBI- NDS members, viz.,
Nationalized Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial Institutions,
Insurance Companies, Mutual Funds, Primary Dealers, etc. Associate Membership to CBLO segment is
extended to entities who are not members of RBI- NDS, viz., Co-operative Banks, Mutual Funds,
Insurance companies, NBFCs, Corporates, Provident/ Pension Funds, etc.

By participating in the CBLO market, CCIL members can borrow or lend funds against the collateral of
eligible securities. Eligible securities are Central Government securities including Treasury Bills, and
such other securities as specified by CCIL from time to time. Borrowers in CBLO have to deposit the
required amount of eligible securities with the CCIL based on which CCIL fixes the borrowing limits.
CCIL matches the borrowing and lending orders submitted by the members and notifies them. While the
securities held as collateral are in custody of the CCIL, the beneficial interest of the lender on the
securities is recognized through proper documentation.

Commercial Paper (CP)

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory
note. Corporates, primary dealers (PDs) and the all-India financial institutions (FIs) that have been
permitted to raise short-term resources under the umbrella limit fixed by the Reserve Bank of India are
eligible to issue CP. CP can be issued for maturities between a minimum of 7 days and a maximum up
to one year from the date of issue.

Certificate of Deposit (CD)

Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form
or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a
specified time period. Banks can issue CDs for maturities from 7 days to one a year whereas eligible FIs
can issue for maturities 1 year to 3 years.

Source: RBI